By Rajendra Nayak, Lubna Kably, Chartered Accountants
Article
There are broadly two ways in which a company may be
financed. One is by the issue of shares in the equity and the other is by
borrowing. The methods by which companies garner their capital affects the
taxation of corporate income. This arises because the computation of the taxable
income of the company and also that of the persons providing the capital are
both affected by the way in which that capital is provided.
In practice, companies are frequently financed partly by
equity contributions and partly by loans. The proportion of a company’s capital
which is financed by each method may well be determined by considerations which
arise from economic or commercial necessity and may have nothing to do with tax.
As a consequence of the fundamental difference between loan and equity capital,
however, the tax treatment of a company and the contributors of its capital also
necessarily differs fundamentally according to whether the capital is equity or
loan capital. With respect to the taxation of its income or profits, the basic
difference is that the shareholder’s reward — the distribution to him of
profits, usually in the form of a dividend — is not deducted in arriving at the
taxable profit of the company. Interest on a loan, however, is usually allowed
as a deductible expense in computing the taxable profits of the company paying
it (being effectively regarded as an expense of earning those profits).
Financial leverage is an important aspect in outbound tax
planning and the planning is typically aimed at effective use (deductibility) of
interest on debt incurred (whether third-party or internal) in conjunction with
a transaction. It may also be possible to claim deduction for interest in more
than one tax jurisdiction through judicious planning.
This can be illustrated as below :
The steps would include :
- The Company in India takes a loan from external sources in India;
- The Company in India funds the Intermediary Company with equity;
- The Intermediary Company gives a loan to the Buy Company (a local company set
up in the same jurisdiction as the target company for the purpose of
acquisition). It also infuses equity into this Company;
- The Buy Company, then acquires the Target Company.
The interest payments on and repayments of the debt are
generally serviced by the Target’s future cash flows, whereas, the debt is
secured by the assets of the Target and the assets of the Buy Company (which in
most instances is a pure holding company).
In the above illustration, it may be possible to claim a
deduction for the interest in India and also in Country B. Further, if tax
consolidation is possible in Country B, then interest costs of the Buy Company
can be offset against the profits of the Target Company. At best, the home
country would only be able to retain a withholding tax on interest payments,
which may again be mitigated or reduced through proper treaty planning.
The expression ‘thin capitalisation’ is commonly used to
describe a situation where the proportion of debt to equity exceeds certain
limits. Thin capitalisation legislation is a tool used by tax authorities to
prevent what they regard as a leakage of tax revenues as a consequence of the
way in which a corporation is financed. Financing a resident corporation with
debt is considerably more efficient from a tax point of view than financing with
equity. The difference in tax treatment is an incentive to provide capital to
the corporation in the form of debt instead of equity. If there are no thin
capitalisation rules, it is relatively easy for a non-resident to advance funds
to a resident corporation in a way that is characterised as debt, so that the
payments on the debt are deductible as interest payments. This is true for
controlling shareholders in particular, because they are probably indifferent to
the form in which their investment is structured, and thus are likely to be
guided by tax considerations when structuring the legal form of their
investment.
The object of Thin Capitalisation Regulations is to prevent the use of excessive ‘in-house’ loans which would be detrimental to the revenue of home country (where the borrower is resident), by reason of the fact that profits would effectively be shifted to the foreign lender, as the interest payments would be tax deductible in the home country.
Countries, through Thin Capitalisation Regulations ensure that the deductions for interest on debt owed to connected parties, is allowable in the home country as a deduction in the hands of the borrower, only if within the permissible limits. While financial leverage has, on its own standing, its own value, this is definitely impaired when interest is not deductible either wholly or partially.
Overview of the Thin Capitalisation Regulations in some key jurisdictions:
A wide variety of methods are used to deal with thin capitalisation in various countries. These approaches range from complex legislation to no specific thin capitalisation legislation at all.
Within this range {our general approaches may be distinguished: (1) the fixed ratio approach (2) the subjective approach (3) application of rules concerning hidden profit distributions; and (4) the ‘no rules’ approach.
The emphasis on the above factors or combinations of factors often varies from country to country. Measures taken by countries to limit excessive debt financing by shareholders are either based on specific legislation or administrative rules or on practice.
Under the ‘fixed ratio’ approach, if the debtor company’s total debt exceeds a certain proportion of its equity capital, the interest on the loan or the interest on the excess of the loan over the approved proportion is automatically disallowed and/or treated as a dividend. The ratio may be used as a safe-haven rule. In this backdrop it should be noted that countries which use the fixed ratio approach usually have specific thin capitalisation legislation.
The basis of the ‘subjective’ approach is to look at the terms and nature of the contribution and the circumstances in which the financing has been made and to decide, in the light of all facts and circumstances, whether the real nature of the contribution is debt or equity. Some countries using the subjective approach have specific legislation. Other countries use more general rules if these are available, such as general anti-avoidance legislation, provisions on ‘abuse of law’, provisions on substance over form. There are also countries that apply ‘hidden profit distribution’ rules to reclassify interest as dividends. In some of these countries the hidden profit distribution rules are applied along , with specific rules which limit the deduction of interest on loans from shareholders. The general principles of transfer pricing rules may also playa role in this respect. The underlying idea is that if the loan exceeds what would have been lent in an arm’s-length situation, the lender must be considered to have an interest in the profitability of the enterprise and the loan, or any amount in excess of the arm’s-length amount, must be seen as being designed to procure share in the profits.
This article provides an overview of the the Thin -‘” Capitalisation Regulations in five major world economies: France, Germany, the Netherlands, the United Kingdom (UK) and the United States (US).
While some countries, like France, have detailed regulations, others like the UK, do not specify a debt: equity ratio, but merely give the right to the Inland Revenue to challenge the interest deductions keeping in view the arm’s-length principle.
France:
Deductibility of Interest – an overview:
New Thin Capitalisation Regulations were introduced for the financial year beginning on or after January 1, 2007. Related party interest falling within the scope of the new Regulations is tax-deductible only to the extent that it meets two tests, which are applicable on a standlone basis at the level of each borrowing company, as opposed to a consolidated basis.
These tests are the Arm’s-Length Test and the Thin Capitalisation Test.
Conditions for disallowance:
Under the Arm’s-Length Test, the interest rate is capped to the higher of the following two rates:
• The average annual interest rate on loans granted by financial institutions that carry a floating rate and that have a minimum term of two year; and
• The interest rate at which the French Company ould have borrowed from any unrelated financial institution (for example, a bank) in similar circumstances.
The portion of interest that exceeds the higher of the above thresholds is not tax-deductible and must be added back to the French Company’s taxable income for the relevant financial year.
Under the Thin Capitalisation Test, the deductibility of interest may be restricted, even if the conditions specified under the Arm’s-Length Test have been met with.
Here, the interest paid in excess of the following three thresholds is not tax-deductible:
The Thin Capitalisation Regulations now stand combined with the General Interest Limitation rules.
• The debt-to-equity ratio threshold, which is calculated in accordance with the following for- The Business Tax Reform (2008), introduced a new mula (The amount of interest that meets the concept for restriction of the interest deduction. The Arm’s-Length Test x 150% of the net equity of restriction applies regardless of whether the inter-the borrower at either the beginning or end of est is paid to a related party or an unrelated lender, the financial year. The total indebtedness of the such as a bank. French borrowing company resulting from borrowing from related companies);
• The earning threshold, which equals 25% of the adjusted current income. The adjusted current income is the operation profit before deducting the following items: tax; related-party interest; depreciation and amortisation; and certain spe-cific lease rents;
• The interest income threshold, which equals interest received by the French Company from related companies.
If the interest that is considered to be tax-deductible under the Arm’s-Length Test exceeds all three of the above thresholds, the portion of the interest that exceeds all three of the above thresholds is not tax-deductible, unless the excess amount of interest lower than Euro 150,000.The nondeductible portion of interest is added back to the taxable income of the borrowing entity. However, it can be carried forward for deduction in subsequent financial years. A 5% reduction applies each year to the balance of the interest carried forward to future financial years beginning with the second subsequent financial year .
Exemptions:
The above thresholds that limit the deductibility of interest do not apply if the French borrowing company can demonstrate that the consolidated debt-to-equity ratio of its group is higher than the consolidated debt-to-equity ratio of the French borrowing Company on a standalone basis (based on its statutory accounts). In determining the consolidated debt-to-equity ratio of the group, French and non-French affiliated companies and consolidated net equity and consolidated group indebtedness (excluding inter-company debt) must be taken into account.
Germany:
Deductibility of Interest – An overview:
The Thin Capitalisation Regulations now stand combined with the General Interest Limitation rules.
The Business Tax Reform (2008), introduced a new concept for restriction of the interest deduction. The restriction applies regardless of whether the interest is paid to a related party or an unrelated lender, such as a bank.
This new Regulation, which is effective for tax years beginning after 25 May 2007 and ending on after 1 January 2008, applies to companies resident in Germany, companies residing abroad but maintaining a permanent establishment in Germany and partnerships with German branch.
Conditions for disallowance:
The new rule disallows’ excess net interest expense,’ which is defined as the excess of interest expenses over interest income if such excess exceeds 30% of the earnings before (net) interest, tax, depreciation and amortisation (EBITDA).
Exemptions:
The limitation rule does not apply if any of the following conditions is satisfied:
• The net interest expense is less than Euro 1 million;
• The Company is not a member of a consolidated group (a group of companies that can be consolidated under International Financial Re-porting Standards);
• The equity ratio of the German subgroup is equal to or higher than the equity ratio for the group as a whole, as shown on the balance sheet of the preceding fiscal year (so-called ‘escape clause’). A ‘group’ is defined as a group of entities that could be consolidated under IFRS, regardless of whether a consolidation has been actually carried out. The escape clause does not apply if any entity in the worldwide group has received loans from a related party not included in the group and if the interest paid on such debt exceeds 10% of the net interest expense.
The Netherlands:
Deductibility of Interest – An overview:
Since 1 January 2004, when the Thin Capitalisation Regulations first came into effect, there have been several amendments, such as broadening the definition of debt.
In general, in the Netherlands, interest expenses (and other costs) with respect to related party loans (or deemed related party loans) may be partly or completely disallowed if the taxpayer is part of a group, as defined under Dutch generally accepted accounting principles (GAAP /international financial reporting standards (IFRS). Further, even if an external debt is formally granted by a third party but is in fact owed to a related party, the Thin Capitalisation Regulations apply.
Conditions for disallowance:
The Regulations provide two ratios to determine the amount of excess debt.
Under the first ratio, which is a fixed ratio, the average fiscal debt may not exceed more than three times the Company’s average fiscal equity plus Euro 500,000. For the purpose of this ratio, debt is defined as the balance of the company’s loan receivables and loan payables. The balance sheet for tax purposes is used to determine the average debt and equity.
The second ratio is the group ratio. When the Company files its corporate tax return, it may elect to apply for the group ratio. Under this alternative, the Company may look at the commercial consolidated debt-to-equity ratio of the (international) group of which it is a member. If the Company’s commercial debt-to-equity ratio does not exceed the debt-to-equity ratio of the group, the tax deduction for interest on related-party loans is allowed.
In certain circumstances, The Dutch Supreme Court has also in its judgements re-characterised loans as informal capital contributions.
The deduction of interest paid including related costs and currency exchange results, by a Dutch company on a related-party loan is disallowed to the extent that the loan relates to one of the following transactions:
• Dividend distributions or repayments of capital by the taxpayer or by a related company or
a related individual resident in the Netherlands;
• Capital contributions by a taxpayer, by a related Dutch company or by a related individual resident in the Netherlands into a related company; or
• The acquisition or extension of an interest by the taxpayer, by a related individual resident in the Netherlands in a company that is related to the taxpayer after this acquisition or extension.
Exemptions:
This interest deduction limitation does not apply if either of the following conditions are satisfied:
• The loan and the related transaction are primarily based on business considerations;
• At the level of the creditor, the interest on the loan is subject to a tax on income or profits that results in a levy of at least 10% on a tax base determined under Dutch standards, disregarding the patent and group interest boxes (which offer certain tax concessions. However, effective from 1 January 2008, even if the income is subject to tax of at least 10% at the level of the creditor, interest payments are not deductible if the tax authorities can demonstrate it to be likely that the loan or the related transaction is not primarily based on business considerations. The measure described in the preceding sentence applies to loans that were in existence on 1 January 2008, with no grandfathering.
The United States:
Deductibility of Interest – An overview:
The US has thin capitalisation principles under which the Internal Revenue Service (IRS) may attempt to limit the deduction for interest expenses if a US corporation is thinly capitalised. In such case, funds loaned to it by a related party may be recharacterised by the IRS as equity. As a result, the corporation’s deduction for interest expense may be considered distributions to the related party and be subject to withholding tax.
Conditions for disallowance:
It can be said that the US adopts a facts-and-circumstances approach in determining whether or not a US corporation is thinly capitalised and whether an instrument should be treated as equity or debt.
While no fixed rules exist, a debt-to-equity ratio of 3 : 1 or less is usually acceptable to the IRS, provided the US corporation can adequately service the debt without the help of related parties.
However, a deduction is disallowed for certain ‘disqualified’ interest paid on loans made or guaranteed by related foreign parties that are not subject to U.S. tax on the interest received. This disallowed interest may be carried forward to future years and allowed as a deduction.
In addition under the US Treasury Regulations, interest expense accrued on a loan from a related foreign lender must be actually paid before the US borrower can deduct the interest expense.
Exemptions:
No interest deduction is disallowed under the above provision if the payer corporation’s debt-to-equity ratio does not exceed 1.5. If the debt-to-equity ratio exceeds this amount, the deduction of any ‘excess interest expense’ of the payer is deferred.
The United Kingdom:
As mentioned earlier, the Regulations in the UK are broad based rather than specific. In other words, UK’s transfer pricing measures apply to the provision of finance (as well as to trading income and expenses). As a result, Companies are required to self assess their tax liability on financing transactions using the arm’s length principle. Consequently, the Inland Revenue may challenge interest deductions on the grounds that, based on all of the circumstances, the loan would not have been made at all, or that the amount loaned or the interest rate would have been less, if the lender was an unrelated third party acting at arm’s length.
European Union (EU) aspects of Thin Capitalisation Rules:
In the case of EU countries, the tax environment is subject to significant external influence in the form of the Ee Treaty and decisions of the European Court of Justice (ECJ). The ECJ decision in the Lankhorst-Hohorst has revived discussions on the compatibility of thin capitalisation rules with the non-discrimination principle of the EC Treaty. The ECJ held in that case that the German thin capitalisation rules which applied only to non-resident companies violated the freedom of establishment provision contained in Article 43 of the EC Treaty. A number of EU countries have thereafter decided to amend their thin capitalisation rules and extent their applicability to resident companies as well.
Thus, in any tax planning exercise involving a financial leverage, Thin Capitalisation Regulations must be taken into cognisance, especially if one of the objectives of such an exercise is to minimise the Global Effective Tax Rate.
